Money Aggregates

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Banking and the Money Supply

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Money Aggregates• Money aggregates

– Measures of money supply– Defined by the Fed

• M1 = Narrow definition of money– Currency and coins held by nonbanking

public– Checkable deposits– Traveler’s checks

2


Money Aggregates• Checkable deposits

– Bank deposits that allow the account owner to write checks to third parties

– ATM or debit cards can also access these deposits and transmit them electronically

3


Money Aggregates• Currency = Fiat money

– Federal Reserve Notes• US Bureau of Engraving and Printing• Issued by & Liabilities of

– 12 Federal Reserve Banks• Two-thirds circulate abroad

– Coins • Manufactured by the U.S. Mint

– Sells them to the Fed at face value

4


Money Aggregates• M2 = Broader definition of money

– M1– Savings deposits

• Earn interest; no specific maturity date– Small-denomination time deposits

• Certificates of deposits, CDs• Earn interest; specific maturity date

– Money market mutual fund accounts• Restrictions

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© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 1

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Measures of the Money Supply (Week of June 20, 2011)


Money Aggregates• Credit cards

– Loan from the card issuer – Repay later– Dispute a charge – Not part of money supply

• Debit cards– From checking account– Part of M1

7


How Banks Work• Banks earn profit

– Attract deposits from savers– Lend to borrowers

• Banks are financial intermediaries– Reduce transaction costs– Cope with asymmetric information– Reduce risk through diversification

8


How Banks Work• Asymmetric information

– A situation in which one side of the market has more reliable information than the other side

• Diversification– Develop a diversified portfolio of assets

• Rather than lending funds to a single borrower

– Reduce the risk to each individual saver

9


Starting a Bank• Home Bank – obtains a charter

– Net worth = Owner’s equity• Shares of stock in the bank

– Balance sheet• Assets = Liabilities + Net worth• Asset – owned by bank

– Physical property– Financial claim– Stock in district Fed

• Liabilities - owed by bank

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Exhibit 2

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Home Bank’s Balance Sheet


Exhibit 3

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Home Bank’s Balance Sheet after $1,000,000 Deposit into Checking Account


Reserve Accounts• Required reserve

– Dollar amount that must be held in reserve

– Required by Fed• Required reserve ratio

– Percentage of checkable deposits (10%)• Must be held in reserve

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Reserve Accounts• Reserves

– Cash in bank’s vault– Deposits at the Fed

• Excess reserves – Bank reserves exceeding required

reserves– Can be used to make loans or to

purchase interest-bearing assets

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Liquidity vs. Profitability• Liquidity

– Ease to convert assets into cash– Safety

• Profitability– Hold more profitable assets

• The objectives of liquidity and profitability are at odds

15


Liquidity vs. Profitability• Federal funds market

– Day-to-day lending and borrowing– Among banks– Interbank market for reserves on account

at the Fed– Interest rate: federal funds rate

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Liquidity vs. Profitability• Federal funds rate

– Interest rate charged in the federal funds market

– Interest rate banks charge one another for overnight borrowing

– The Fed’s target interest rate

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How Banks Create Money • Creating money through excess reserves

– Round one• Fed buys $1,000 US government bond

– Creates reserves • Money supply: +$1,000• Required reserves: +$100• Excess reserves: +$900

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Exhibit 4

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Changes in Home Bank’s Balance Sheet after the Fed Buys a $1,000 Bond from Securities Dealer



– Round two• $900 loan• Money supply: +$900• Required reserves: +$90• Excess reserves: +$810

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Exhibit 5

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Changes in Home Bank’s Balance Sheet after Lending $900 to You



– Round three• $810 loan• Money supply: +$810• Required reserves: +$81• Excess reserves: +$729

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Exhibit 6

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Changes in Merchants Trust’s Balance Sheet after Lending $810 to English Major



– Round four and beyond• Excess reserves – new loans• Required reserves: +10% of new checkable

deposits– Excess reserve – maximum amount for

loans– Money supply expansion

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How Banks Create Money • A summary of rounds

– Fed: $1,000 injection in fresh reserves– Increased excess reserves– Money supply increase: up to $10,000

• Checkable deposits– Banking system

• Eliminates excess reserves– Expand money supply

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Exhibit 7

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Summary of the Money Creation Resulting from the Fed’s Purchase of $1,000 U.S. Government Bond


Reserve Requirements• Assumptions

– No bank holds excess reserves– Borrowed funds don’t sit idle– People don’t want to hold more cash

• Required reserve ratio = r• Simple money multiplier = 1/r• Change in the money supply = Change

in fresh reserves ˣ 1/r

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Reserve Requirements• Money multiplier

– The multiple by which the money supply changes• As a result of a change in fresh reserves in

the banking system• Simple money multiplier, 1/r

– Reciprocal of the required reserve ratio– Maximum multiple of fresh reserves by

which the money supply can increase

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Reserve Requirements• Excess reserves

– Fuel the deposit expansion process– A higher reserve requirement

• Drains this fuel from the banking system• Reducing the amount of new money that

can be created

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Limitations of Money Expansion• Leakages from expansion

– Smaller money multiplier– Cash – preferred to checking accounts

• People hold money• Fewer excess reserves

30


Multiple Contraction• The Fed sells a $1,000 bond

– Money supply: -$1,000– Required reserves: -$900– Recall loans– Money supply: -$900– Required reserves: -$810– Maximum effect

• Decrease money supply = Original decrease in reserve requirements ˣ 1/r

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The Fed’s Tools• Open-market operations

– Buy / sell US government bonds• The discount rate

– Interest rate, the Fed– For loans made to banks

• The required reserve ratio– Minimum fraction of reserves

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Open-Market Operations• Increase money supply

– The Fed buys US bonds• Open-market purchase

• Reduce money supply– The Fed sells US bonds

• Open-market sale• Tool of choice for the Fed• Influences bank reserves• Influences federal funds rate

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The Discount Rate• Discount rate

– Interest rate charged by the Fed– Loans to banks

• Bank borrow ‘Discount window’– Satisfy reserve requirements

• The Fed– Lender of last resort

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The Discount Rate• Primary discount rate• Secondary discount rate• Signal to financial markets

– Monetary policy• Emergency tool

– Injecting liquidity

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Reserve Requirements• Required reserve ratio• Money creation for each dollar of fresh

reserves• Disruptive

– Banking system

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Coping with Financial Crisis• Regulation of financial markets• Prevents major disruptions and financial

panics• Sufficient liquidity in the financial system• 2007

– Discount rate from 6.25% to 0.5%• Encouraged banks to borrow from the Fed

• Paying interest on bank reserves held at the Fed

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Coping with Financial Crisis• Invested more than a $1 trillion in

mortgage-backed securities• Invested more than $90 billion in AIG• Provide sufficient liquidity to reduce the

harm of mortgage defaults on the overall economy

• Stockpiles extra cash in bank vaults around the country and around the world

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The Fed is a Money Machine• Assets (most earn interest)

– Mortgage-baked securities (50%)– U.S. government bonds (33%)

• From open-market operations– Foreign currencies– AIG investments

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The Fed is a Money Machine• Liabilities

– Federal Reserve notes outstanding (40%)• U.S. currency

– Reserves• The Fed is a money machine

– Supplies Federal Reserve notes– Main assets: earns interest– Main liability: no interest payment

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Exhibit 8

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Federal Reserve Bank Balance Sheet as of June 29, 2011 (Billions)

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Money Aggregates

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